Clients might also opt for a return of principal rider. If the client deposits $200,000 and the stock market drops to $100,000, the beneficiary will receive the original investment, minus withdrawals. Also available at added cost is a rider that increases the account value by a given percentage annually, such as a 5%, subject to a 200% cap. This “step-up” option may appeal to many boomers nearing retirement, but may not be suitable for younger boomers who are likely to experience more than a 200% market gain in their account value, says Ethan Young, manager of annuity research at Commonwealth Financial Network, Waltham, Mass. By comparison, GLB riders, while boosting potential payouts for heirs, are more often than not purchased for the benefit of the annuity investor, Young says. With GLBs, “clients are more willing to use an annuity for what it was originally intended, which is to provide an income stream you can’t outlive,” says Young. “Because they’re paying for the rider, clients are more likely to spend down the annuity’s assets, leaving little or nothing for heirs. Also, some contracts will eliminate the death benefit because of their design.” To illustrate, Young points to contracts where withdrawals reduce the death benefit proportionally (i.e., by the percentage the withdrawal represents of the cash value). When the death benefit exceeds the current cash value, as is typical in a down market, the proportional reduction method yields a lower death benefit than does the dollar-for-dollar reduction method, which simply reduces the death benefit by the amount of the withdrawal. Example: Assume an initial investment of $400,000 in a VA that uses the proportional method. If the client withdraws $50,000 annually for 4 years and then dies, the contract could actually yield a zero death benefit, as opposed to $200,000 under the dollar-for-dollar method. Many contracts that incorporate a GLB rider, notes Young, use the proportional reduction technique to help fund the optional living benefit. “The difference between the dollar-for-dollar and proportional methods is not often explained to clients,” says Young. “And I doubt whether many advisors even know about the two techniques.” While the dollar-for-dollar method may be advantageous to consumers in a bear market, it is potentially disastrous for the insurer, say industry experts. To illustrate the point, Bobb Meckenstock, founder and president of Mainstreet Securities, Hays, Kan., cites a financial “horror story” of the 1990s. This was the bankruptcy of Boston-based All America Financial, then a leading VA insurer with more than $10 billion in VA assets. Because the company failed to reinsure the death benefit guarantees on its VAs–guarantees that were more generous than any other offered at the time and that were calculated according to the dollar-for-dollar method, Meckenstock says–All America’s cash reserves ran dry when the company had to pay out death benefits during the market plunge of the early 2000s. “An annuity originally holding $220,000 annuity might have dropped to a market value of $89,000 and the company had to pay the difference,” says Meckenstock. “The result was the firm was put out of business.” How else can advisors secure an enhanced death benefit for heirs? One option, say experts, is to do a 1035 exchange of one VA for another during a bull market, thereby locking in a step-up in basis, or a higher account value not subject to ordinary income tax. Assuming the transaction entails no surrender charge on the original VA, the exchange–and the gain–cost the client nothing. Also available is an estate protection rider. This add-on, which can boost a final account value upon the owner’s death often by as much as 150%, covers ordinary income tax paid by estate beneficiaries. This rider has a potentially steep cost, though. According Herb Daroff, a partner at Baystate Financial Services, Boston, Mass., it can add an extra 50 to 80 basis points in premium. Unless the client is uninsurable or would have to pay a prohibitive amount of premium due to advanced age or ill health, says Daroff, the client could transfer wealth to heirs more cost effectively by purchasing a life policy. Unlike the annuity, life insurance proceeds are distributed income tax-free. In cases where the rider does make sense and the client opts for a laddering strategy–purchasing annuities in increments–then the rider should be supplemented with other optional living benefits. “If I have $1 million in retirement assets, and I did five $200,000 buckets (in VAs), then we’ll only put the estate protection rider on the last one,” says Daroff. “But for buckets to be spent down prior to death, I’ll add a guaranteed minimum income or withdrawal benefit. The magic of the annuities is all in the riders.” But because that magic comes at price, advisors need to disclose the additional charges fully, including the management and separate account fees. Says Brent Welch, a managing member at Welshire Capital, Onalaska, Wis.: “If, after learning how much is to be paid [in additional charges] for the annuity, the client still decides the product is worth the cost, then the client would be a suitable candidate for investing at least some of the assets in a VA guarantee.” Riders aside, observers caution advisors to be mindful of the annuity’s structure. If the contract is “owner-driven,” then it will only pay a death benefit upon the death of the policy owner. An “annuitant-driven” policy, by contrast, will only pay upon the death of the annuitant. The contract structure isn’t an issue where both policy owner and annuitant are the same individual, as is usually the case. But when two individuals are involved, then advisors need to ensure the policy is designed to achieve the desired outcome. “If you want funds to go to children upon mom’s death, and the contract is owner-driven, then mom had better be designated the owner,” says Young. “One way to achieve this is by getting a joint owner-joint annuitant policy, but some contracts will only pay out at the second death. What’s important is that advisors understand the contract structure.” That word of caution applies as well to traditional fixed annuities, specifically those offering a lifetime payout. Life-only annuities continue distributions until death, with no death benefit payable to beneficiaries, sources emphasize. However, other fixed contracts, such as life with period certain and joint and survivor annuities, will provide a death benefit if contract requirements are met (e.g., the annuitant passing away before all guaranteed payments are made). Contract design is an important consideration, too, with fixed indexed annuities. Meckenstock cautions producers against marketing FIAs that don’t pay out the full contract value at death. Historically, he says, many of these products required clients to annuitize the contract over any remaining surrender period in order for beneficiaries to receive the death benefit. But Young counters that’s no longer the case today. Today’s FIAs “function more like traditional fixed annuities, providing full value at death without having to annuitize,” he says, adding “the products have become much more client-friendly.” However much improved, FIAs, traditional fixed annuities and VAs won’t distribute death benefits as intended if the contract’s beneficiary designations aren’t kept current. To that end, Young encourages producers to meet at least annually with clients to review beneficiaries, as well as those stipulated in other estate plan documents, such as wills and trusts. They also need to counsel clients about the tax implications of both spousal and non-spousal beneficiaries. Whereas a spousal beneficiary can assume ownership of a contract with no tax consequences, a non-spousal beneficiary doesn’t have this option, says Young. Ditto in cases where a trust is both owner and beneficiary–even when the spouse is trustee. “The result is there will be no step-up in basis at death and the trust will pay a higher tax on any gain,” says Young. “Also, because they’re non-natural entities, trusts cannot annuitize contracts, as there is no way to do a lifetime benefit calculation.” To learn more about death benefits, see When clients want to change beneficiaries by Linda Koco.